The Price Is Right: Auction Theory for NPL Markets

Bhaswar Chakma

2025-05-14

NPL

Background on NPLs

  • Non-Performing Loans (NPLs) = loans unlikely to be repaid.
  • Weaken bank balance sheets → reduced lending and credit supply.
  • Challenge: Build an efficient, competitive market for NPLs.

NPLs on the balance sheets of European banks

  • At the end of 2017: €770 billion of troubled loans

  • 7% of the whole euro area GDP

IMF Suggestions & East Asian Approach

IMF:

  1. Stronger banking regulation.
  2. Faster legal enforcement (e.g., insolvency reform).
  3. Develop a secondary market for NPLs.

East Asia:

  • Created public Asset Management Companies(AMCs) in late 1990s to purchase portfolios of NPLs.

The European Banking Authority(EBA) Proposal (2017)

  • Proposed by EBA Chair Andrea Enria.
  • Create an EU-backed Asset Management Company (AMC).
  • AMC buys NPLs at Real Economic Value (REV), not market price.
  • Includes clawback clauses and stress testing provisions.

EBA Proposal: Strengths

✅ Reduces information asymmetry via due diligence.
✅ Aggregates volume to improve liquidity.
✅ Encourages banks to sell by using REV instead of market price.

EBA Proposal: Weaknesses

❌ Does not fix market power or collusion.
❌ Clawback clause prevents full removal from balance sheets.
❌ Possible conflict with EU State Aid rules.
❌ Banks may still hesitate to sell if losses return later.

Authors’ View

  • AMC can eliminate information asymmetry

  • But cannot tackle market power and collusion

  • Auction theory can be of great help:

    • Attract many diverse bidders.
    • Prevent collusive behavior.
    • Ensure truthful bidding.
    • Allow flexible supply based on demand.

Product-Mix Auction: The Solution

  • Invented by Paul Klemperer, used by Bank of England.
  • Bidders submit sealed bids across multiple varieties (e.g. secured/unsecured NPLs).
  • Uniform pricing per variety.
  • Single round, quick and resistant to manipulation.

Product-Mix Auction: Bidding Stage

The bank plans to auction NPLs, divided into two separate portfolios:

  • Secured NPLs: Loans backed by collateral (e.g. real estate, vehicles).
    If the borrower defaults, the lender can seize the asset.

  • Unsecured NPLs: Loans with no collateral backing.
    Recovery depends entirely on legal action or restructuring.

Each bidder can submit offers on one or both types.
Prices are submitted as percentages of nominal (book) value.

Product-Mix Auction: Bids submitted

Bidder Quantity (€M) Secured Price Unsecured Price
A 800 51% 35%
B 600 53% 37%
C 750 56% 40%
D 550 50% 38%

Product-Mix Auction: Cutoff & Allocation

The bank chooses:

  • Cutoff: 55% (secured), 37.5% (unsecured)
Bidder Quantity (€M) Secured Price Unsecured Price
A 800 51% 35%
B 600 53% 37%
C 750 56% ✅ 40% ✅
D 550 50% 38% ✅

Why Product-Mix Auction Works

✅ Uniform pricing → encourages truthful bidding
✅ Simultaneous bidding → avoids guessing across markets
✅ No entry deterrence → small bidders can compete
✅ Single round → fast and resistant to collusion

Critique of the Authors’ Proposal

  • ❌ Assumes fully rational bidders:

  • ❌ No solution to bank reluctance:

    • Authors assume banks will willingly participate, but fear of loss exposure may block participation.

  • ❌ Assumes deep, liquid markets:

    • Not all NPL classes attract enough bidders, especially under distressed conditions.

Conclusion

  • EBA proposal is a strong start, inspired by IMF and Asian models.
  • But auction design still matters.
  • Product-Mix Auction: practical, scalable, competition-friendly.
  • Auction theory = a vital tool to unlock better financial markets.